The volatility (vol) anomaly, the phenomenon of low-volatility stocks outperforming high-volatility stocks, has been well researched. The authors show the persistent impact of the vol anomaly on actual mutual fund returns. Fund manager skill is eliminated when a vol factor is added to the standard four-factor equity model.
What’s Inside?
The authors find that the volatility (vol) anomaly greatly affects actual mutual fund returns. A dollar invested in a portfolio of mutual funds with low past return volatility at the beginning of 2000 is worth $2.90 at the end of 2013, whereas a portfolio with high past return volatility is worth only $1.21. The authors demonstrate that a one-standard-deviation increase in fund volatility in the prior year predicts a decrease in alpha of 1.0%.
High-vol mutual funds usually contain substantial small-cap and growth weightings, but these factors do not explain underperformance. The authors find that the underperformance of high-vol mutual funds is explained completely by exposure to the vol anomaly. They suggest that low-vol funds hold stock in companies that are more profitable and invest more conservatively than companies whose stock is held by high-vol funds.
How Is This Research Useful to Practitioners?
If some mutual fund managers have skill, then it is valuable to be able to identify them. The authors show that in the context of the Fama–French four-factor model, a portfolio of low-volatility funds has an alpha of about 1.8% per year and a portfolio of high-volatility funds has an alpha of about –3.2% per year. Because the vol anomaly is so significant, failure to account for it can lead to an incorrect assessment of manager skill by naive fund investors. When this factor is included in the model analysis, manager skill is insignificant.
Additionally, the authors review numerous studies, research, and references for the vol effect. Portfolio managers and product development professionals who intend to launch a low-vol equity fund may find the review useful.
How Did the Authors Conduct This Research?
The authors build a sample of actively managed US equity funds from the CRSP database. The funds are sorted into portfolios based on past return volatility. At the beginning of each year, the authors sort funds into deciles based on the standard deviation of their daily fund returns during the prior calendar year. The time period January 2000–December 2013 is used because of the availability of daily fund data. The low-vol portfolio holds the 10% of mutual funds in the sample with the lowest standard deviation. The high-vol portfolio holds the 10% of mutual funds with the highest standard deviation. Each portfolio is equally weighted and has the same number of funds at the start of the year. The persistence of fund volatility as a predictor of future fund performance is tested by adding vol as a factor to the monthly Fama–French four-factor model for the low- and high-vol portfolios.
An appendix is included with a modified sample that begins in 1992; it thus includes the internet bubble (1999–2002), when the high-volatility portfolio outperformed and doubled in value in less than one year. Despite including this period, the long-term results remain consistent because an investor would have accumulated more wealth from substantially less risky investments with a portfolio of low-vol mutual funds.
Abstractor’s Viewpoint
Proper measurement of fund manager skill is essential when choosing active managers and negotiating an appropriate manager fee for equity management. The large volume of assets moving into low-volatility equity strategies makes the analysis in this research very timely and relevant. The popularity of low-vol equity strategies has resulted in low-vol stocks currently trading at a premium. It will be interesting to see how these strategies perform in a rising interest rate environment and to read the authors’ follow-up research in this area.